Europe and Depositor Preference

When banks fail, should depositors be burned alongside holders of senior bank debt or should debt holders lose money before depositors are touched?

That question, now under consideration in Brussels as part of discussions over a new “resolution regime” for dealing with failing European banks, is topical after the Cyprus rescue package imposed losses on big depositors in that country’s two largest banks.

In Cyprus, once a decision had been made to limit its rescue to €10 billion, there wasn’t much choice but to burn bank depositors: Cypriot banks hadn’t raised much funding from bondholders. But, there will usually be more debt to “bail in”—as the jargon has it—when a bank fails in the future.

The idea that depositors should be preferred in bank resolution over bondholders—known as depositor preference—is well established in the U.S.

When a bank fails, the Federal Deposit Insurance Corporation pays out uninsured depositors—which include itself after it has taken over the claims of insured depositors—before any other claimants.

The U.S. experience is an argument in itself for Europe to adopt a similar rule. “Depositor preference is what they have in the U.S. and the U.S. system is what works least bad,” said Nicolas Véron, of the Brussels-based Bruegel think tank.

Depositor preference in some form is also baked into legislation in a number of EU countries, including Germany and the U.K. The main advantage appears to be that it increases depositor confidence and reduces the risk of bank runs in a crisis.

The European Parliament has picked up on this issue. The commission proposal, as it stands now, is too unclear on where uninsured depositors sit in the pecking order, says Gunnar Hökmark, a lawmaker from Sweden who will lead the Parliament’s negotiations on the file with EU member states.

“Unprotected depositors will still be the last to be bailed in,” he predicted, adding that he expects a firm depositor preference to be one of the key issues that lawmakers will fight for in their negotiations.

But the issue is not clear cut and there are potential disadvantages to depositor preference. Preferring depositors explicitly may increase the cost of funding for banks, and potentially further weaken the market in inter-bank loans. Some policy makers worry also that depositor preference could also provide incentives for banks to pay over the odds for deposits, and therefore encourage depositor recklessness about where they put their money.

Whatever solution is settled upon, it’s bound to affect investor choice. If there’s a straightforward depositor preference, certificates of deposit are likely to be favored by investors over like-maturity bank bonds.

Officials and lawmakers are also deliberating over whether to exclude inter-bank loans of less than one month from bail-in. Excluding short-term deposits would reassure the key market in overnight bank loans, but could well make the inter-bank market less stable by encouraging lenders to keep loan maturities below one month.

Ideally, a resolution regime would treat risk-taking investors of similar rank alike, whether they have formally invested in deposits or bank debt. It should distinguish such investors from depositors using banks to make payments, including, for example, companies using large deposits to pay workers. In practice, drawing this line precisely, as the Cypriot case showed, is hard to achieve.

About Real Time Brussels

The Wall Street Journal’s Brussels blog is produced by the Brussels bureau of The Wall Street Journal and Dow Jones Newswires. The bureau has been headed since 2009 by Stephen Fidler, who was previously a correspondent and editor for the Financial Times and Reuters. Also posting regularly: Matthew Dalton, Viktoria Dendrinou, Tom Fairless, Naftali Bendavid, Laurence Norman, Gabriele Steinhauser and Valentina Pop.